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How future contracts are terminated?
Future contracts
These are a standardized agreements between parties −
One party commits to sell stipulated quantity, quality of commodities, securities or any other specific items at particular price on or before future date (agreed in agreement)
Daily settlements of all Gains/losses (till status of contract is open)
Provides either physical delivery or cash settlement
Features
Buyer (LONG) agree to receive delivery
Seller (SHORT) agree to make delivery
Traded on exchanges (either by Pits or electronically)
Can be terminated prior to contract expiration (by offsetting transactions)
Future contract has a underlying instrument (currency, commodity etc.), size (amount of underlying item covered in contract), delivery cycle, expiration date, quality specification, delivery location and settlement mechanism
Who trade on future contract
Hedgers
Speculators
The clearing house
| Pros | Cons |
|---|---|
| Less upfront cost | Amplified losses |
| Investors can speculates in future market | Sometimes investors lose advantage of favorable price |
A trade (either holding a long or having short position in future contract) can terminate the contract by following ways −
Close out − In close out, traders close the contract before expiry date. In same contract, a trader holding long position can take short position (equivalent) to offset both the positions or in the same contract, a trader having short position can take long position to closeout.
Delivery − In this, short settles the contract by delivering the asset to long on settlement date. This method is not frequently used for settlements. In case of physical settlement, clearing house will select the counter party (hold oldest long position) who accepts delivery.
Cash settlement − This is the commonly used method to save transaction cost of trader in closing out the position. In this, when contract expires, traders position is open and margin account of trader will be market to market for profit and loss.
Exchange for physicals − It is also called ex-pit transaction (outside exchange floor). In this, trader exchange physicals to terminate contract. Trader finds another in same future contract, who holds opposite position to deliver underlying assets.
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